On that basis, we could say that 2012 was good one for the central bankers and that this year is shaping up as one for the traders — at least in currency markets, where trading activity is up by as much as 50% from a year earlier for the biggest foreign exchange banks.

The world’s most important currencies have broken out of the tight ranges of last year, threatening a return of volatility that’s driving investors and multinational companies to ramp up their hedging activity. That means more business for the traders who execute these people’s orders, but it’s not necessarily good news for the world as a whole. An uncertain outlook for currencies makes it harder to do international business and drives up the cost of hedging.

Why the economy is declining

(20:00)

Economist John Mauldin on the state on the U.S. economy, and a look at how some companies are opening up their closely held secrets to employees.

Interestingly, both the torpor of 2012 and the frenzy of 2013 can be pinned on those very same stability-loving central banks. After overseeing an uneasy peace for many months with their interventionist efforts, they are now inadvertently fomenting a revival in foreign exchange volatility.

Well, to be fair, most people are blaming just one central bank: the Bank of Japan. And even there, real fault lies with Japan’s new Prime Minister, Shinzo Abe, who has ridden roughshod over the BOJ’s independence to jawbone it into a more proactive monetary policy that’s now driving down the yen.

The sharp drop in the Japanese currency — 15% against the dollar since mid-September, 18% versus the euro — has disrupted the equilibrium in world exchange rates. To take one example, the South Korean won’s gains versus the yen are making it harder for Samsung and Hyundai to compete with Sony and Honda. Inevitably that results in a weaker won, which is now sliding versus the dollar as traders anticipate the competitive blow to South Korean. That of course means that South Korea’s competitors are under pressure too. So, the Taiwan dollar is falling as well, which in turn means the Thai baht and Singapore dollar are also slipping, and so forth.

How to invest over the next 45 days

(4:45)

The next 45 days are a time to move, but which way?

But for all of Shinzo Abe’s dangerous forays into mercantilist nationalism, Japan is no lone shooter. While its economic doldrums are mostly the culmination of an insufficient strategy for reversing the deflation of the past two decades, its export-dependent economy’s recovery has not been made any easier by the market interventionism that others have adopted in lieu of more effective reforms to encourage economic growth.

Whether it’s China’s manipulation of the yuan to perpetuate an outdated export-led economy, the Federal Reserve’s $2.5 trillion in money printing to stabilize the U.S. economy while Washington dithers, or the European Central Bank’s use of bank lending and sovereign bond backstops to battle a crisis that politicians couldn’t overcome, the rest of the world has been intervening prodigiously. And whether intentionally or not, this changes exchange rate dynamics and poses a competitive threat to places like Japan. It’s impossible to say who threw the first stone.

Whoever’s to blame, the world has brought itself as close to a global currency war as it has been since the crisis. As Morgan Stanley economists Manoj Pradhan and Patryk Drozdik pointed out in a research note this week, Japan’s actions have introduced “competitive depreciation” into the international financial arena and that poses a serious challenge to policymakers. Many in emerging markets — whose currencies are most prone to unwanted appreciation from the excess liquidity that advanced country central banks have pumped into the world economy — are again taking matters into their own hands. Peru has vowed to purchase $2 billion in foreign bonds to drive down its currency, the sol. Meanwhile, exchange rate-sensitive central banks in China, India, Taiwan, South Korea, and Turkey are sticking with easy monetary policy at a time when they should be gearing up for inflationary risks.

As Pradhan and Drozdik suggest, the best solution for policymakers stuck in this bind is to undertake structural reforms that make their economies more competitive in spite of their appreciating exchange rates. Politically that’s easier said than done, of course, but it’s really the only way out of this dangerous spiral of reaction and counter-reaction.

Without such a response, the world economy faces significant risks — even if, for now, it’s providing some relief to currency traders.

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